This paper uses a structural model to investigate the pricing of investment grade credit risk during the financial crisis. Our analysis suggests that the dramatic recent widening of credit spreads is highly consistent with the decline in the equity market, the increase in its long-term volatility, and an improved investor appreciation of the risks embedded in structured products. In contrast to the main argument in favor of using government funds to help purchase structured credit securities, we find little evidence that suggests these markets are experiencing fire sales.

Lots of people are commenting (including Austrians!) that this paper proves that the structured credit securities are not overpriced. Sadly, they don’t really come to any opinion on it at all. It has one of those econ paper flaws where they model something that is kind of cool, and then tack on an expansive public policy guide that is only tangentially related to the issue at hand.

They take a calibrated a structural Merton Model of credit risk and applied it to the current market. Equity is just a call option on assets with the debt as the strike price. Huh? You have bills to pay at all times, and you have assets – money, stuff you can sell, which are random. If your assets are ever less than the bills you owe, you are bankrupt. Equity is worthless in a bankruptcy. It becomes quasi-trivial to apply Black-Scholes to figure out how likely it is you’ll go bankrupt, and how much that asset call option is worth. Very cool theory out of the first wave of 1970s Black-Scholes stuff; constantly being referred to, most notably, to me at least, by a guy named Hayne Leland. Back to the paper.

They find that this relationship between equities and investment grade debt makes sense throughout the crisis, and that the increase in spreads at the investment grade reflects a change in expectations, and not a failure of markets (in the liquidity, fire sale, etc. sense).

This has nothing to do with the legacy assets. They don’t go anywhere near it. They find that there isn’t a firesale or liquidity issues in the investment grade market, but that is necessary but not sufficient to make their argument. Economics of Contempt calls it correctly, from what I can see. The funny part is that it is an excellent paper at what it does – but during the last page they can’t help themselves and assume that their results are applicable to everything, everywhere, when they haven’t even broken dirt on what an honest evaluation would look like. And they are not humble in the least at that….

One Response to Legacy Asset Valuation

Yeah, that paper ranks up there as one of the most misleading, if not deliberately dishonest, academic papers I’ve read in a long while. But then again, finance professors who spend their whole careers in academia are known for their propensity to write unintentionally hilarious “scholarly” articles (or at least they were when I was in grad school). So I guess you get what you ask for when you read their working papers.